PIMCO has significant top-down and bottom-up expertise dedicated to understanding the U.S. housing market cycle. In 2006, we warned U.S. housing prices were significantly overvalued, which led to our defensive positioning heading into the recession. In 2011, we turned bullish on real estate and added investments such as non-agency mortgage-backed securities, banks and homebuilders that we felt would benefit from an eventual recovery in housing prices.

The questions for many are what’s next for housing and, importantly, what are today’s investment opportunities? While each investor needs to consider their own financial situation and risk tolerance, here are a few big picture themes and bottom-up opportunities and sectors to consider now to capitalize on the next phase of the housing recovery cycle.

First, home equity is rising. The Federal Reserve recently cited positive data and trends with homeowners’ equity. One year ago, 22% of homes in America were in a negative equity position whereas today only 13% of homes with mortgages are underwater, according to CoreLogic. Game changer? Not yet, but the trend is quite positive. Going forward, U.S. consumers are likely to spend more on remodeling, particularly as home equity and housing prices rise. In fact, Harvard’s Joint Center for Housing Studies is projecting home improvement spending will grow on average 10% in 2014. Home improvement companies are seeing the recovery in remodel activity starting with small projects like a fresh coat of paint, but increasingly large-scale projects such as kitchen and bathroom renovations should pick up. For the December quarter, a large Michigan-based home improvement company reported a double-digit increase in sales in North America driven by volume growth in cabinets, paint and windows. Investors should favor home improvement and appliance manufacturers that should benefit not only from a pickup in remodel spending but also a continued cyclical rebound in housing starts.

Second, companies are raising prices. Many housing-related companies cut capacity in the last recession in order to prepare for an eventual recovery. This has facilitated pricing power during the upturn. While U.S. housing starts are up over 20% annually in the past two years, according to the U.S. Census Bureau, the housing industry is still under-building. New home construction is running at 1 million units per year, well below long-term demand of around 1.4 million units. Moreover, housing inventory is near a 30-year low as a percentage of the working age population. Want more good news? Several companies, having cleaned up their balance sheets and downsized coming out of the last recession, are now in a strong position to benefit as more homes are built and remodeled. What specific sector should benefit most? Building materials! Many of these companies are now experiencing mid- to high-single-digit gains in both volumes and pricing. In terms of pricing, recent increases are continuing and coming on top of already large price increases for some companies. As evidence, a large Chicago-based building materials company with leading market positions was able to raise prices for gypsum wallboard, a key construction material, by 17% in 2012 and by 17% again in 2013, with additional price increases announced for 2014. When a firm’s sales growth is accelerating and the company has pricing power, that’s a good signal that you might want to own that company. Own building materials.

And lastly, the consumer is healing. Consumers have made significant progress deleveraging their balance sheets. In addition, the U.S. economy added over 2 million private sector jobs last year, according to the Bureau of Labor Statistics. While income growth remains modest, consumer confidence and “animal spirits” have improved due to higher equity and home prices and a supportive central bank. Consumers will likely open up their wallets more this year and take that vacation they have been putting off. Planes and lodging will be more crowded, so own airlines and hotels to benefit from the consumer’s improved ability and willingness to spend.

The U.S. housing market may have come a long way over the last two years. But we still see significant opportunity in the sector as the next leg of the housing recovery takes hold.

The COVID-19 crisis is likely to accelerate many underlying, secular disruptive forces already affecting economies and financial markets. This may only increase the difference between those companies, sectors, and countries that are being disrupted, and those that are acting more like disruptors. Distinguishing between the two is becoming crucial.

Disclosures

All investments contain risk and may lose value. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

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